<%@ LANGUAGE=VBScript %> <% Set asplObj=Server.CreateObject("ASPL.Login") asplObj.Protect Set asplObj=Nothing %> Analysis of IBM's 3Q09 business results (Oct 16)

Annex Bulletin 2009-20                           October 16, 2009

A partially OPEN edition

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Updated 10/16/09, 12:00PM HIT

Analysis of IBM's Third Quarter Business Results

IBM Stock Takes a Beating

... Despite Better-than-expected Quarterly Results; When Reason Takes a Holiday on Wall Street

HAIKU, Maui, Oct 16 – IBM stock took a beating today, dropping over six points or five percent to close at $121.30.  When the company released its third quarter results last night, both earnings and revenues were better-than-expected.  Free cash flow set a new record.  Revenues increased sequentially.  The IBM CFO said in a conference with analysts that revenues would actually grow year-over-year in the fourth quarter as well.  As a result, Big Blue raised its full year earnings-per-share forecast from $9.70 to $9.85.

No wonder most headlines lauded the IBM results (see below). 

TOP GOOGLE NEWS HEADLINES AS OF 4PM FRIDAY, OCT 16

IBM Corporation Expands Analytics And Risk Management Capability In Ireland ; Reuters Key Development - 5 hours ago

International Business Machines Corp. Beats Analyst Expectations; IBM, JAVA, HPQ ; Learning Markets - 7 hours ago

IBM's Q3 Profit Rises 14%, Guidance Lifted (IBM); Dividend.com - 7 hours ago

IBM reports 14% profit growth for Q3 and raises outlook ; Trading Markets - 10 hours ago

Yet investors shrugged off the facts and sold off the stock anyway (see the chart).  Which is what happens on Wall Street every now and then when reason takes a holiday and emotion takes over. 

"We expected them to exceed expectations on both numbers" (earnings and revenues), is how one analyst tried to "explain" the inexplicable (see CNBC, Oct 15).

"Expected them to exceed expectations?" 

In other words, IBM is to be judged by Wall Street's wishful thinking not by their published estimates?  If so, what are Wall Street estimates for if they really do not represent what analysts really think?  A fig leaf for incompetence?

Which is why we prefer to stick to facts.  So here's what we told our clients shooting from the hip, right after the IBM results were released last night:

IBM’s third quarter results confirm that the global economic recovery is under way, with “new age” tech companies, like IBM, Google, Apple etc. leading the way.   Yes, count the industry’s oldest company as one of the trailblazing ones in the new age of the Internet, cloud computing and global networking environment.

Big Blue beat both Wall Street earnings and revenue estimates.  Not by much.  But both the $2.40 EPA and $23.6B revenues, up sequentially from the 2Q, are actually more than meets the eye.  Why?  The second and third quarters of 2008 were unseasonably strong for IBM.  So the latest report is actually better than it appears at face value.   

With the worst of the prior year comparisons now behind IBM, we expect the fourth quarter revenues actually to GROW.  Which would make it the first growth quarter this year.

The real story of the third quarter was IBM’s expanding margins.  They grew across the board, even in business whose revenues have declined.  And IBM has improved its gross margins in 20 or the last 21 quarters.  Which once again goes to show that the IBM business model is virtually “recession proof.”

So there you have it... our précis of Big Blue's latest results, based on FACTS.  You can contrast that with the way Wall Street reacted to them.  And now some more details...

Business Segment Analysis

IBM third quarter revenues declined 7% (down 5% in constant currency), but were up sequentially from the second quarter, as we noted earlier.

Geographies. Americas’ revenues were $9.9 billion, a decrease of 5% (down 4% in constant currency).  Europe dropped 12% to $7.8 billion (down 6% in constant currency).  Asia/Pacific revenues were essentially flat at $5.2 billion (down 4% in constant currency). OEM revenues were $634 million, down 6% compared with the 2008 third quarter.

Revenues from the company’s growth markets organization also decreased 6% (1% in constant currency), and represented 19% share of the total of geographic revenues.  But they outpaced the more mature IBM market by five growth points, with China's revenues surging 26%.

Industries. IBM's government sector was the best performer in the third quarter, with flat revenues as reported (up 2% in constant currency).  Financial services was also solid, declining only 3% (down 2% in constant currency).   Manufacturing and distribution sectors were the weakest, dropping 15% and 11% respectively (down 14% and 9% in constant currency).  IBM's SMB (small and medium size businesses - General Business [GB] in IBM nomenclature), which Big Blue expected to be its best growth opportunity two years ago, dropped 9% (down 6% in constant currency).

Services. As goes services, so goes Big Blue these days.  IBM Global Services revenues declined 7% (down 5% in constant currency), the same rates of change as IBM's as a whole.  New contract signings dropped by the same amount.

Someone Wall Street tried to explain the emotional sell-off of the IBM stock by pinning the blame on the decline in new contract signings in the third quarter.  But that's just like watching the offence on the field in a football or baseball game.  It misses half the game.  The other half - defense, is just as important.  And IBM has evidently played excellent defense, since its backlog rose by $2 billion to $134 billion (see the chart).  It was the second quarter in a row that IBM has been able to add to its backlog while its new contract signings dropped.

So those who blamed the contract signings for IBM's alleged "woes" only managed to show their ignorance of how a services business works. 

Furthermore, the CFO Mark Loughridge said during the post-release teleconference with analysts that IBM signed three deals in the first two days of October with a total value of nearly $1 billion.

"These three deals would have pushed our outsourcing growth rate to 16% at constant currency, which is consistent with the first half performance of 18% growth," he said.  He added that, "with a solid start to the quarter and looking at the pipeline of deals we have, we should be able to grow outsourcing signings double-digits in the fourth quarter."

Even without those mega deals, IBM's outsourcing signings grew 1% in the third quarter.  So if IBM services had a weakness, it was in the consulting and systems integration business.

Software. Revenues from the software segment were $5.1 billion, a decrease of 3% (flat, adjusting for currency).  But IBM’s key middleware products, which include WebSphere, Information Management, Tivoli, Lotus and Rational products, grew by 2% to $2.9 billion (up 5% in constant currency).  Operating systems revenues of $521 million decreased 12% (down 8%, adjusting for currency) compared with the prior-year quarter.

IBM said it gained market share in WebSphere, Information Management, Tivoli and Rational software during the third quarter.  But the most distinguishing feature of IBM's software is its high profitability.  At 86% gross margin, it is by far the company's most profitable segment.  And as you could see from the pretax profit chart above, the software contributes more dollars to Big Blue's bottom line than any other business segment, including the bigger services operations.

Hardware. Revenues from the Systems and Technology segment totaled $3.9 billion for the quarter, down 12% (11% in constant currency).  But that rate of decline represented an improvement in the year-to-year revenue growth rate compared with the second quarter of 2009.

Revenues from System z mainframe server products decreased 26%.   System p dropped 10%, System x rose 1%, while storage dropped 13%.   Revenues from Microelectronics OEM decreased 1%.

IBM said it gained market share in System p, System x and disk and tape storage during the third quarter despite shrinking revenues.  Meaning, it was winning business from its direct competitors whose revenues declined even more.

Summary

It is impossible to interpret emotional decisions using rational arguments.  There is no way, therefore, to explain Wall Street's negative reaction to IBM's solid third quarter results.  So the only thing left to say by way of a summary is that IBM shares are today even more undervalued than they were over a week ago when we restated our assessment that they were undervalued (see A Rally of Hope over Fact, Oct 5).  Which would make them an even better buying opportunity for the investors who are willing to bet that the current rally of hope over fact will continue.

In other words, having depending on reason and logic seems detrimental in this type of a market.  What happened to the IBM stock in the last 24 hours underlines that in spades.

Click here for detailed IBM business segment tables and charts (Annex clients only)

Happy bargain hunting!

Bob Djurdjevic

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Volume XXIII, Annex Bulletin 2009-20
October 16, 2009

Bob Djurdjevic, Editor
e-mail: annex@djurdjevic.com

Tel/Fax: +1-602-824-8111

(c) Copyright 2009 by Annex Research, Inc. All rights reserved.
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